Ebook The Case for a Financial Approach to Money Demand
Although money is a dominated asset, it is widely held in the economy. Theories of money demand focus on various frictions to explain this puzzling fact, either in the goods market to model a transaction role for money (e.g., shopping&time and cash&in&advance (CIA) models), or in financial markets via the so&called Baumol& Tobin Model (Allais, 1947; Baumol, 1952; Tobin, 1956). Other theories introduce a fiscal constraint which force money holding (Diamond and Rajan, 2006) or simply assume a liquidity role for money, as in models with the money in the utility function (MIUF). These theories are observationally equivalent in aggregate data: they can be realistically calibrated to match various estimates, such as the interest elasticity of money demand. In this paper, it is shown that microeconomic data can be used to discriminate between these different theories: Household data reject baseline models of money demand, such as the CIA, baseline MIUF, shopping&time models or models based on a fiscal constraint, but theories based on financial frictions are able to reproduce realistic distributions of money, consumption and wealth.
In both Italian and US data, the distribution of money (M1) is similar to that of financial wealth, and much more unequally distributed than is that of consumption (as measured by the Gini coeq cient, for example). In 2004, the Gini coeq cients were around 0.3 for consumption, 0.8 for net wealth and 0.8 for money. This stylized fact, further detailed below, holds for different definitions of money, various time periods, and after controlling for life&cycle effects. This distribution of money cannot be understood in standard macroeconomic models where money demand is introduced via CIA, MIUF or shopping&time considerations. In these models, real money bal& ances are proportional to consumption, and the distributions of money holdings and consumption should be equally distributed among households (i.e. have the same Gini coeq cient). As shown below, this diq culty in reproducing the distribution of money holds even when we consider more general transaction technologies on the goods market, which may produce scale economies. In addition to its theoretical interest, the ability to reproduce the distribution of money is crucial for the assessment of the real and welfare effects of inflation. When money holdings are widely dispersed, inflation can be expected to have significant distributional effects.
Two theories present themselves as good candidates to explain the fact that the distribution of money is similar to the distribution of financial wealth. The first is a financial theory of money demand, which was introduced by Allais, Baumol and Tobin in their inventory approach to monetary theory. Households face a fixed adjustment cost in financial markets, because of which they participate only infrequently in financial markets. Between two periods of participation, they hold money to smooth consumption. In this theory, the friction is introduced in the financial markets and not in the goods market. The second is a fiscal theory of money demand, as mentioned by Diamond and Rajan (2006) amongst others. Households have to pay taxes with money and thus must hold money. In consequence, heterogeneity in taxes induced by heterogeneity in labor and financial income can help explain the heterogeneity in money holdings. The result of this paper is that a realistic joint distribution of consumption, money and financial assets can be reproduced with the financial theory of money only, whereas the fiscal theory of money is not able to reproduce a realistic distribution of money.
More specifically, I first assume that money holdings can be freely adjusted, but that there is a transaction cost of adjusting the quantity of financial assets. To focus on the fiscal and financial motive to hold money, it is assumed that households do not need money to make purchases, and do not face a cash&in&advance constraint. I thus assume that the payment system is well organized, so that the transaction demand for money is close to zero. Second, a realistic linear tax system is introduced and I assume that households must hold money to pay at least a given fraction of their taxes. These two foundations for money demand are introduced into a production economy where infinitely&lived agents face uninsurable income fluctuations and borrowing constraints, a framework often described as the VBewley&Huggett&AiyagariV environment. In this type of economy, households choose between two assets with different returns, but also different transaction costs, in order to smooth idiosyncratic income fluctuations. This type of economy does not introduce life cycle considerations and is thus well&suited for the analysis of heterogeneity within generations. The model is calibrated to reproduce the idiosyncratic income fluctuations faced by US households. The transaction cost and the fraction of taxes paid in money are chosen to match the average quantity of money held by households in the US economy.
Closing off alternatively the fiscal and financial channels for money demand, I find that only the financial channel is able to generate a realistic joint distribution of money and financial assets. This result is robust to various changes in the model parameters, and to modeling choices. In particular, although the participation cost in the financial market affects the average amount of money held, it does not significantly change the dispersion in the distribution of money holdings. This is because households hold money to smooth consumption without paying transaction costs in financial markets. They only participate infrequently in financial markets to increase their financial savings when their money holdings are high, and to dissave when their money holdings are low. Between these two boundaries, which depend on household wealth, money is used as an asset to smooth consumption. Consequently, although the amount saved in money is on average much less than that invested in financial markets, the dispersion of the distributions of money and assets remain similar to each other.
Download
PDF Ebook The Case for a Financial Approach to Money Demand
Posted in :
